What Would ECB Easing Look Like?

The European Central Bank (ECB) is different from the Federal Reserve in a few different ways. It's mandate is different in that it only is meant to keep price stability whereas the Fed is meant to protect a dual mandate of "full" employment and price stability. This divergence has huge implications for how the central banks have enacted policy to fend off financial crises since 2008.

The Federal Reserve has used quantitative easing to fight deflation and reflate assets to avoid a depression. Due to its dual mandate, the Fed has continued to act to boost employment even as inflation stays above the long-term average. The Fed has accepted extra inflation as an effect of easing policies, a stance not shared by the ECB. The ECB is looked at by many as a European Bundesbank, where the large German contingent in the bank has a loud voice.

Bundesbankers fear inflation more than anything. The fear of hyperinflation in Germany dates back to the Weimar Republic, when the Bundesbank printed money to fight the Great Depression, only to see hyperinflation cripple the spending power of consumers. This fear of inflation limits the scope of the ECB's policy responses.

The ECB will not do a full-blown QE for these reasons. However, measures such as the LTRO's, considered QE Light by some analysts, remain on the table. In the LTRO's the ECB gives cheap loans to banks in exchange for collateral, which does expand its balance sheet. However, as they are loans and are collateralized, the ECB protects itself and has a fixed timetable in which the printed money gets recalled. Further LTRO's are more likely than full-blown QE.

Also, the ECB still has room to cut rates. The benchmark lending rate is only at 0.75 percent, as compared to the Fed's benchmark rate which effectively zero. The ECB could cut rates by a further 25 basis points to 0.5 percent to spur growth. The ECB could also re-activate its Securities Markets Program (SMP), the program in which it buys sovereign bonds in the open market to cap yields. The ECB already owns about 250 billion euros of sovereign debt in this program and fears of a seniority crisis a la the Greek restructuring will probably keep this program dormant.

The ECB and the Fed both have interest rate decisions and meetings next week. Because Mr. Draghi has "shown his hand" Thursday, it may be that the Fed decides to take a wait and see policy at its meeting next week. It is clear that a large part of the U.S. slowdown can be traced to Europe and so action from the ECB may be enough to revive the U.S. economy.

Rate cuts and any other policies would most likely cause a short-term pop in the EUR/USD and cause peripheral bond yields to fall. However, after the initial pop, the EUR/USD would most likely decline, either based on interest rate differentials or an expanded money supply. In either case, peripheral yields would most likely fall as investors realize that the ECB may step up and backstop the troubled sovereign finances.